Compass Has Successfully Monetized Some Assets, But Core Growth Remains An Issue - Compass Diversified Holdings LLC (NYSE:CODI)

Compass has significant capital it can redeploy into M&A, and the shares aren't too expensive now, but management will need to balance the needs for both growth and near-term cashflow.

Kudos to Compass Diversified Holdings (CODI) management with the sales of Manitoba Harvest and Clean Earth in 2019, as the company obtained strong valuations (at least in terms of EV/EBITDA and EV/revenue) for those two assets. With around $950 million coming in, Compass has more options for redeploying capital, including some debt reduction alongside more M&A.

One of the biggest issues I’ve had with Compass still remains, though, and that’s the relatively weak prospect for core distributable cash flow. Cash available for distribution has grown at only a low-to-mid single-digit rate, and the distribution hasn’t changed in over five years, tempering the excitement over the 7%-plus yield that it offers. I can’t say I’m all that excited about the underlying businesses within the Compass family, though the shares do look reasonably-priced for investors who want a more income-heavy return structure.

In February and May of this year, Compass announced two significant transactions – selling Manitoba Harvest to Tilray (TLRY) for over C$ 400M and selling Clean Earth to Harsco (HSC) for $625M. In both cases, I believe Compass got good prices. Manitoba Harvest was sold at over 4x my 2019 revenue estimate for a business generating single-digit EBITDA margins and Compass generated a roughly 37% annualized return on investment for the company. For Clean Earth, while Harsco believes they’re paying less than 10x forward EBITDA including synergies, the purchase price was around 13x-14x most sell-side EBITDA estimates for the business. ROI is a little harder calculate here, since the company made subsequent follow-on deals, but a $625 million purchase price versus $359 million for the initial deal and seven follow-on transactions suggests a pretty good return.

While I have no qualms with the prices that Compass got, these deals do undermine the growth story somewhat. Manitoba Harvest had yet to really take off, and a strategic buyer like Tilray may be able to do more with it, but this is a business that I thought had above-average long-term potential (assuming a few things went the company’s way). Clean Earth had been an above-average grower for Compass, and I believe it would have continued to be one of the growth leaders.

Bulls can argue that these transactions validate management’s strategy and prove that the company can identify winners early, buying them, developing them, and then selling them later at attractive multiples. Bears can argue that they were some of the better growth assets in the portfolio and that now the company is even more reliant on mediocre assets like Liberty and slow-growth businesses like Advanced Circuits.

I think the truth is somewhere between. Compass is a patient holder (I don’t believe they do a deal unless they’re comfortable holding indefinitely), but they’re also perfectly willing to sell assets when the right opportunity comes along. The multiples for both Manitoba Harvest and Clean Earth were quite healthy and I think management is maximizing their value by selling them, though now the onus shifts back to management to find “the next” Manitoba Harvest or Clean Earth.

As is probably readily apparent, I’m not hugely bullish on Compass’s current portfolio. I believe 5.11 Tactical is a good business, and one that could have significant upside if it catches wider public interest, but I’m not nearly so bullish on Velocity Outdoors or ERGObaby, as both have been hit hard by a changing retail environment and changing consumer behaviors. With Liberty, I see an “is what it is” low-growth business with unexciting margins. All told, the consumer business shrank slightly on both the top line and EBITDA line in Q1’19, and results weren’t that impressive in Q4’18 or Q3’18 either (excluding Manitoba Harvest).

The industrial businesses are doing better, with revenue up 4% and EBITDA up 5% in Q1, but none of these business is likely to generate more than low-single-digit organic revenue growth over the next few years. Advanced Circuits may benefit some from the trade dispute with China and Arnold Magnetic could benefit from ongoing growth opportunities in EVs and motors, but Compass doesn’t seem to really be investing for growth here.

Why harp on growth? If Compass is going to pay higher distributions in the future, it’s going to have to be supported by underlying earnings growth. A collection of assets with low organic EBITDA growth potential is going to make that more challenging. With around $1 billion in deployable capital, though, I expect Compass to be actively looking for new deals, and I will be curious to see how the company balances the needs/demands for near-term contributors to distributable cash flow with longer-term growth potential (it’s tough to get both at a reasonable price).

During the late June investor day, management once again acknowledged that they were considering converting to a C-corp structure. Doing so would allow for Compass to be included in indices and it would also allow mutual funds to hold the shares, while simplifying the tax reporting for many individual investors. Similar conversions were generally welcomed at Ares (ARES), Blackstone (BX), and KKR (KKR), but due to U.S. tax laws, it’s pretty much a one-way move and a one-time decision, so I don’t blame management for taking their time on this. To that end, a final decision may well not come until after the next presidential election in the U.S.

Between subtracting Manitoba Harvest and Clean Earth, adjusting my modeling assumptions for the individual businesses, and reconsidering some of the forward multiples, my distributable cash-based fair value moves up into the low $20’s (from the high teens), while my sum-of-the-parts EBITDA approach fair value stays about the same in the high teens. I’m expecting low single-digit long-term revenue growth (closer to the mid-single-digits on an organic basis, adjusted for the asset sales) from the current collection of businesses, and mid-single-digit cash flow growth, but I do expect management to deploy capital into M&A and that will boost the long-term revenue growth rate.

I’ve had my issues with Compass over the years, including what I feel is an overly generous fee structure for a business that hasn’t produced particularly impressive reported financial or share price performance results. On the other hand, management did make a shareholder-friendly move in waiving management fees for the “excess” cash on the balance sheet after the Manitoba and Clean Earth deals, and Compass management has been increasing its stake by buying in the open market (at prices around $19). With a yield that looks pretty secure and some modest potential upside on a long-term cash flow basis, I can respect this as a decent buy-and-hold idea for investors who want more income-dominant returns, but I still have concerns about the long-term value of a collection of businesses that don’t seem to offer much growth individually or collectively.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Seekingalpha.com

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